What are the new year’s most prominent risks?

Key Points

Risk is a constant in financial markets, but some timeframes bring greater challenges than others.

Higher interest rates and tensions with China stand out as prominent risks in 2019.

Despite challenges, the U.S. economy should see another year of expansion.

Market volatility caused some uncertainty for investors in 2018. The S&P 500 experienced declines of approximately 10% on two different occasions, and interest rates finally started to move tangibly higher, putting pressure on bond prices.

Still, the economy in 2018 looks likely to post its best rate of expansion in more than 10 years, and earnings per share for the S&P 500® Index are projected to grow by more than 20%, according to data provider FactSet.

The experience of the past year reminds us that volatility is a normal part of the investment landscape. Regardless of economic or market conditions, obstacles can arise that create uncertainty.

In our view, the two most prominent challenges to growth in 2019 are:

The pace at which interest rates rise.

The ongoing trade dispute between the U.S. and China.

The potential impact of higher interest rates

Rising interest rates can slow economic growth, crimp corporate profit margins, and act as a headwind for stock prices as bonds become comparatively more attractive. Historically, there have also been instances when Federal Reserve officials have been criticized for pushing interest rates beyond what the economy could reasonably accommodate, resulting in an economic downturn.

Presently, Fed officials are projecting three interest rate hikes of 0.25% in 2019. Other interest rates that impact consumers, such as mortgage and automobile financing rates, are likely to follow the trend. The pace of U.S. economic growth is likely to slow from the impressive level of growth seen this past summer, and international growth has already decelerated modestly. Inflation pressures remain below forecasts. Should these conditions persist, the Fed may have leeway to temper the pace of interest rate hikes in response.

If economic conditions were to improve, we believe three Fed rate hikes would be appropriate in maintaining a balance between growth and inflation.

Tensions with China

The U.S.’s trade dispute with China, however, could pose the greater risk to the intermediate-term outlook. Disruptions in the free flow of trade can slow global growth, while tariffs could result in higher consumer prices (i.e., inflation).

Though the very large U.S. trade deficit with China receives the most headlines,1 the crux of the dispute with China is its track record of intellectual property theft and state-sponsored efforts to dominate certain high-value industries. Such policies are a serious threat to the economic viability of all developed economies, and any near-term economic pain would likely be minor compared to the long-term consequences of maintaining the status quo. Conversely, the situation could improve dramatically should China’s leadership realize that the world is not going to return to its prior stance of ignoring such policies. China can agree to a fair playing field, still grow its economy quite well and raise its standard of living without behaviors that are so clearly unfair to its global trading partners.

Fundamentals remain solid

While it is possible that new challenges may emerge that create uncertainty for the markets, we believe the most likely outcome for U.S. markets is a generally positive one. The U.S. economy is positioned for another year of good, yet modestly slower, economic growth. Corporate earnings growth is also likely to continue but will probably decelerate as the initial boost from corporate tax cuts fades.

S&P 500® Index earnings per share are currently expected to see growth of about 9.5% in 2019, according to FactSet. This is a bit stronger than historical norms. The primary risk to this expectation is that earnings growth could see a more pronounced slowdown should relations with China deteriorate. Another potential obstacle to profit growth is the risk of a stronger dollar, which makes U.S. exports more expensive internationally and results in lower returns on foreign-generated profits.

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